Download Chapter 12

Spreadsheet Modeling
& Decision Analysis
A Practical Introduction to
Management Science
6th edition
Cliff T. Ragsdale
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be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part.
Chapter 12
Introduction to Simulation
Using Risk Solver Platform
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accessible website, in whole or in part.
On Uncertainty and Decision-Making…
"Uncertainty is the most difficult thing about
decision-making. In the face of uncertainty, some
people react with paralysis, or they do exhaustive
research to avoid making a decision. The best
decision-making happens when the mental
environment is focused. …That fined-tuned focus
doesn’t leave room for fears and doubts to enter.
Doubts knock at the door of our consciousness,
but you don't have to have them in for tea and
crumpets."
-- Timothy Gallwey, author of The Inner Game of
Tennis and The Inner Game of Work.
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accessible website, in whole or in part.
Introduction to Simulation
 In many spreadsheets, the value for one or
more cells representing independent
variables is unknown or uncertain.
 As a result, there is uncertainty about the
value the dependent variable will assume:
Y = f(X1, X2, …, Xk)
 Simulation can be used to analyze these
types of models.
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accessible website, in whole or in part.
Random Variables & Risk
 A random variable is any variable whose value cannot
be predicted or set with certainty.
 Many “input cells” in spreadsheet models are actually
random variables.
– the future cost of raw materials
– future interest rates
– future number of employees in a firm
– expected product demand
 Decisions made on the basis of uncertain information
often involve risk.
 “Risk” implies the potential for loss.
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Why Analyze Risk?
 Plugging in expected values for uncertain cells tells us
nothing about the variability of the performance
measure we base decisions on.
 Suppose an $1,000 investment is expected to return
$10,000 in two years. Would you invest if...
– the outcomes could range from $9,000 to $11,000?
– the outcomes could range from -$30,000 to $50,000?
 Alternatives with the same expected value may
involve different levels of risk.
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Methods of Risk Analysis
 Best-Case/Worst-Case Analysis
 What-if Analysis
 Simulation
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Best-Case/Worst-Case Analysis
 Best case - plug in the most optimistic
values for each of the uncertain cells.
 Worst case - plug in the most pessimistic
values for each of the uncertain cells.
 This is easy to do but tells us nothing
about the distribution of possible outcomes
within the best and worst-case limits.
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Possible Performance Measure
Distributions Within a Range
worst case
best case
worst case
best case
worst case
best case
worst case
best case
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What-If Analysis
 Plug in different values for the uncertain cells
and see what happens.
 This is easy to do with spreadsheets.
 Problems:
– Values may be chosen in a biased way.
– Hundreds or thousands of scenarios may be
required to generate a representative distribution.
– Does not supply the tangible evidence (facts and
figures) needed to justify decisions to
management.
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Simulation
 Resembles automated what-if analysis.
 Values for uncertain cells are selected in an
unbiased manner.
 The computer generates hundreds (or
thousands) of scenarios.
 We analyze the results of these scenarios to
better understand the behavior of the
performance measure.
 This allows us to make decisions using solid
empirical evidence.
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Example: Hungry Dawg Restaurants
 Hungry Dawg is a growing restaurant chain with a
self-insured employee health plan.
 Covered employees contribute $125 per month to
the plan, Hungry Dawg pays the rest.
 The number of covered employees changes from
month to month.
 The number of covered employees was 18,533 last
month and this is expected to increase by 2% per
month.
 The average claim per employee was $250 last
month and is expected to increase at a rate of 1%
per month.
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accessible website, in whole or in part.
Implementing the Model
See file Fig12-2.xlsm
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accessible website, in whole or in part.
Questions About the Model
 Will the number of covered employees really
increase by exactly 2% each month?
 Will the average health claim per employee
really increase by exactly 1% each month?
 How likely is it that the total company cost will
be exactly $36,125,850 in the coming year?
 What is the probability that the total company
cost will exceed, say, $38,000,000?
© 2011 Cengage Learning. All Rights Reserved. May not
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accessible website, in whole or in part.
Simulation
 To properly assess the risk inherent in the
model we need to use simulation.
 Simulation is a 4 step process:
1) Identify the uncertain cells in the model.
2) Implement appropriate RNGs for each uncertain
cell.
3) Replicate the model n times, and record the value
of the bottom-line performance measure.
4) Analyze the sample values collected on the
performance measure.
© 2011 Cengage Learning. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part.
What is Risk Solver Platform?
 Risk Solver Platform (RSP) is a spreadsheet addin that simplifies spreadsheet simulation.
 A limited-life trial version of RSP is available with
this book.
 It provides:
– dialogs & functions for generating random numbers
– commands for running simulations
– graphical & statistical summaries of simulation data
 For more info see:http://www.solver.com
© 2011 Cengage Learning. All Rights Reserved. May not
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accessible website, in whole or in part.
Random Number Generators (RNGs)
 A RNG is a mathematical function that
randomly generates (returns) a value from a
particular probability distribution.
 We can implement RNGs for uncertain cells
to allow us to sample from the distribution of
values expected for different cells.
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accessible website, in whole or in part.
How RNGs Work
 The RAND( ) function returns uniformly distributed
random numbers between 0.0 and 0.9999999.
 Suppose we want to simulate the act of tossing a
fair coin.
 Let 1 represent “heads” and 2 represent “tails”.
 Consider the following RNG:
=IF(RAND( )<0.5,1,2)
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Simulating the Roll of a Die
 We want the values 1, 2, 3, 4, 5 & 6 to occur
randomly with equal probability of occurrence.
 Consider the following RNG:
=INT(6*RAND())+1
If 6*RAND( ) falls
in the interval:
0.0 to 0.999
1.0 to 1.999
2.0 to 2.999
3.0 to 3.999
4.0 to 4.999
5.0 to 5.999
INT(6*RAND( ))+1
returns the value:
1
2
3
4
5
6
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Generating Random Numbers
With Risk Solver Platform
 RSP uses “Psi” functions to implement RNGs in
spreadsheets
– “Psi” functions
 Used in formulas like any other Excel function
 Require RSP to be installed on the machine displaying the
spreadsheet
– The Distribution Gallery
 Displays graphical depictions of RNG distributions to assist in
selecting the appropriate Psi function
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Some of the RNGs Provided
By Risk Solver Platform
Distribution
RNG Function
Binomial
PsiBinomial(n,p)
Chi-Square
PsiChisquare(λ)
Poisson
PsiPoisson(λ)
Continuous Uniform PsiUniform(min,max)
Exponential
PsiExponential(λ)
Triangular
PsiTriang(min, most likely, max)
Normal
PsiNormal(μ,σ)
Truncated Normal PsiNormal(μ,σ, PsiTruncate(min,max))
(And there are many others)
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Using Psi Functions
Click Insert
Function icon
Select Psi distribution
Select Psi function
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accessible website, in whole or in part.
Using the Distribution Gallery
1. Click Distributions
2. Select distribution
3. Specify parameters
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Examples of Discrete Probability
Distributions
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Examples of Continuous Probability
Distributions
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Discrete vs. Continuous
Random Variables
 A discrete random variable may assume one of a
fixed set of (usually integer) values.
– Example: The number of defective tires on a new
car can be 0, 1, 2, 3, or 4.
 A continuous random variable may assume one
of an infinite number of values in a specified
range.
– Example: The amount of gasoline in a new car
can be any value between 0 and the maximum
capacity of the fuel tank.
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accessible website, in whole or in part.
Preparing the Model for Simulation
 Suppose we analyzed historical data and
found that:
– The change in the number of covered
employees each month is uniformly distributed
between a 3% decrease and a 7% increase.
– The average claim per employee follows a
normal distribution with mean increasing by
1% per month and a standard deviation of $3.
© 2011 Cengage Learning. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part.
Revising & Simulating the Model
See file Fig12-6.xlsm
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Psi Functions for Analyzing
PsiOutput( ) Cells
Psi Function
Meaning
PsiMax(x)
PsiMin(x)
PsiMean(x)
PsiStdDev(x)
PsiPercentile(x, y)
PsiTarget(x,y)
PsiExpLoss(x)
PsiExpGain(x)
Returns maximum of output cell x
Returns minimum of output cell x
Returns mean of output cell x
Returns std dev of output cell x
Returns yth percentile of output cell x x
Returns P( x < y)
Returns E( x<0 )*P(X<0)
Returns E( x>0 )*P(X>0)
(And there are many others)
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The Uncertainty of Sampling
 The replications of our model represent a sample from
the (infinite) population of all possible replications.
 Suppose we repeated the simulation and obtained a
new sample of the same size.
Q: Would the statistical results be the same?
A: No!
 As the sample size (# of replications) increases, the
sample statistics converge to the true population
values.
 We can also construct confidence intervals for a
number of statistics...
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Constructing a Confidence Interval
for the True Population Mean
95% Lower Confidence Limit = y-1.96 
s
n
95% Upper Confidence Limit = y  1.96 
s
n
where:
Also note that PsiMeanCI( ) calculates
the half-width of the confidence
y  theinterval
sample for
mean
the mean.
s = the sample standard deviation
n = the sample size (and n  30)
Note that as n increases, the width of
the confidence interval decreases.
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Constructing a Confidence Interval for
the True Population Proportion
95% Lower Confidence Limit = p-1.96 
95% Upper Confidence Limit = p  1.96 
p (1  p )
n
p (1  p )
n
where:
p  the proportion of the sample that is less than some value Yp
n = the sample size (and n  30)
Note again that as n increases, the width
of the confidence interval decreases.
© 2011 Cengage Learning. All Rights Reserved. May not
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Additional Uses of Simulation
 Simulation is used to describe the behavior,
distribution and/or characteristics of some
bottom-line performance measure when values
of one or more input variables are uncertain.
 Often, some input variables are under the
decision makers control.
 We can use simulation to assist in finding the
values of the controllable variables that cause
the system to operate optimally.
 The following examples illustrate this process.
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An Reservation Management Example:
Piedmont Commuter Airlines
 PCA Flight 343 flies between a small regional airport
and a major hub.
 The plane has 19 seats & several are often vacant.
 Tickets cost $150 per seat.
 There is a 0.10 probability of a sold seat being vacant.
 If PCA overbooks, it must pay an average of $325 for
any passengers that get “bumped”.
 Demand for seats is random, as follows:
Demand
14 15 16 17 18 19 20 21 22 23 24 25
Probability
.03 .05 .07 .09 .11 .15 .18 .14 .08 .05 .03 .02
 What is the optimal number of seats to sell?
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Random Number Seeds
 RNGs can be “seeded” with an initial value that
causes the same series of “random” numbers to
generated repeatedly.
 This is very useful when searching for the optimal
value of a controllable parameter in a simulation
model (e.g., # of seats to sell).
 By using the same seed, the same exact scenarios
can be used when evaluating different values for
the controllable parameter.
 Differences in the simulation results then solely
reflect the differences in the controllable parameter
– not random variation in the scenarios used.
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Implementing & Simulating the Model
See file Fig12-18.xlsm
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accessible website, in whole or in part.
Using a Multiple Cumulative
Frequency Chart to Compare
Alternatives…
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Inventory Control Example:
Millennium Computer Corporation (MCC)





MCC is a retail computer store facing fierce competition.
Stock outs are occurring on a popular monitor.
The current reorder point (ROP) is 28.
The current order size is 50.
Daily demand and order lead times vary randomly, viz.:
Units Demanded: 0
1
2
3
4
5
6
7
8
9 10
Probability:
0.01 0.02 0.04 0.06 0.09 0.14 0.18 0.22 0.16 0.06 0.02
Lead Time (days): 3
4
5
Probability:
0.2 0.6 0.2
 MCC’s owner wants to determine the ROP and order size
that will provide a 98% service level while minimizing
average inventory.
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Implementing & Simulating the Model
See file Fig12-22.xlsm
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accessible website, in whole or in part.
Optimizing the Model
See file Fig12-27.xlsm
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Risk Contstraints
 Value at Risk (VaR)
– Specifies the % of trials that can violate a
constraint
 Condition Value at Risk (CVaR)
– Specifies a bound on the average
magnitude of constraint violation
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Using Trends Charts to Compare
Reorder Policies…
Original
Optimal
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A Project Selection Example:
TRC Technologies
 TRC has $2 million to invest in the following new R&D
Revenue Potential
projects.
Project
1
2
3
4
5
6
7
8
Initial Cost Prob. Of
($1,000s) Success
$250
0.9
$650
0.7
$250
0.6
$500
0.4
$700
0.8
$30
0.6
$350
0.7
$70
0.9
($1,000s)
Min Likely Max
$600 $750 $900
$1250 $1500 $1600
$500 $600 $750
$1600 $1800 $1900
$1150 $1200 $1400
$150 $180 $250
$750 $900 $1000
$220 $250 $320
 TRC wants to select the projects that will maximize the
firm’s expected profit.
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Implementing & Simulating the Model
See file Fig12-39.xlsm
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accessible website, in whole or in part.
Risk Considerations
 The solution that maximizes the
average profit also poses a significant
risk of losing money.
 Suppose TRC would prefer a solution
that maximizes the chances of earning
at least $1 million…
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A Portfolio Optimization Example:
The McDaniel Group
 $1 billion available to invest in merchant power plants
Fuel
MWs
Generation Capacity per Million $ Invested
Gas
Coal
Oil
Nuclear
Wind
2.0
1.2
3.5
1.0
0.5
Fuel
Mean
St Dev
Normal Dist'n Return Parameters
Gas
Coal
Oil
Nuclear
16%
12%
10%
9%
12%
6%
4%
3%
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Wind
8%
1%
A Portfolio Optimization Example:
The McDaniel Group
 Returns from different types of plants are correlated
Fuel
Gas
Coal
Oil
Nuclear
Wind
Gas
1
Return Correlations by Fuel
Coal
Oil
Nuclear
Wind
-0.49
-0.31
-0.16
0.12
1
-0.41
0.11
0.07
1
0.13
0.09
1
0.04
1
 How much should be invested in each type of plant?
 What is the efficient frontier?
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Implementing & Simulating the Model
See file Fig12-43.xlsm
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accessible website, in whole or in part.
Efficient Frontier Obtained
Using Multiple Optimizations
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End of Chapter 12
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accessible website, in whole or in part.
The Risk Solver Platform software
featured in this book is provided
by Frontline Systems.
http://www.solver.com
© 2011 Cengage Learning. All Rights Reserved. May not
be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part.